Economic Integration, Corporate Tax Incidence and Fiscal Compensation

• Published date: 01 November 2016
• Author: Nelly Exbrayat,Benny Geys
• DOI: http://doi.org/10.1111/twec.12323
• Date: 01 November 2016

Economic Integration, Corporate Tax

Incidence and Fiscal Compensation

Nelly Exbrayat

1

and Benny Geys

2,3

1

GATE Lyon-Saint-Etienne, Universit

e de Lyon, Saint-Etienne, France,

2

Norwegian Business School BI,

Oslo, Norway, and

3

Vrije Universiteit Brussel (VUB), Brussels, Belgium

1. INTRODUCTION

Asubstantial literature going back to at least Harberger (1962) argues that corporate taxes

exert a negative impact on wages as long as the capital supply is not completely inelastic

(i.e. a tax incidence effect; Harberger, 1962, 1995). A more recent literature suggests that the

causal connection between corporate taxes and wages might well be reversed because g overn-

ments could have an incentive to compensate firms for high labour costs by reducing corpo-

rate taxes (Haufler and Mittermaier, 2011; Exbrayat et al., 2012; Mittermaier and Rincke,

2013). While not denying the relevance of tax incidence effects, casual observation appears to

corroborate the existence of such fiscal compensation effects. For instance, the UK instituted

a national minimum wage in 1998, and simultaneously introduced substantial cuts in its cor-

porate income tax rate. The same pattern –that is a decrease in corporate taxation following

an increase in the minimum wage level –also materialised in several Canadian provinces

(including British Columbia and Ontario) and the United States (where president Bush condi-

tioned his support for a minimum wage increase in May 2007 on business tax breaks). Hence,

it appears that ‘fiscal policies are used to compensate investors for the location disadvantages

of facing high wages’ (Haufler and Mittermaier, 2011, p. 795).

Thus far, empirical analyses of the tax–wage relation assess either corporate tax incidence

on wages (Randolph, 2006; Des ai et al., 2007; Felix and Hines, 2009; Dwenger et al., 2011;

Arulampalam et al., 2012; Fuest et al., 2012; Clausing, 2013) or fiscal compensation for

higher wage costs (Mittermaier and Rincke, 2013), and ignore the potential bidirectional nat-

ure of this relation. The first contribution of this paper therefore lies in simultaneously testing

for both a tax incidence and a fiscal compensation effect in a data set comprising 24 OECD

countries over the period 1982–2007. Although previous studies control for reverse causality

using, for instance, instrumental variables techniques, our simultaneous estimation of both

relations is important since the bidirectional, negative relationship between corporate taxes

and wages suggested in the theoretical literature can only be accommodated via such an

approach.

Our second, and arguably more important, contribution lies in extending the existing

empirical literature via the first evaluation of the moderating role of capital mobility for both

tax incidence and fiscal compensation effects. With respect to the fiscal compensation effect,

economic theory provides a clear prediction. As the risk of capital outflows becomes more

prominent with the integration of global economies, the potential negative effects of rising

wage costs (including capital outflows, or reduced inflows) strengthen with increasing capital

mobility. This is likely to make rational governments more inclined to provide compensation

for high wages through the corporate tax system –for instance, by implementing compensat-

ing corporate tax discounts (Haufler and Mittermaier, 2011; Exbrayat et al., 2012).

With respect to the tax incidence effect, it is important to take into account the exact

nature of the wage setting process. In the presence of a wage bargaining process, a so-called

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The World Economy (2016)

doi: 10.1111/twec.12323

The World Economy

direct tax incidence arises because corporate taxation reduces the quasi-rent over which work-

ers and firms can bargain. Arulampalam et al. (2012) and Fuest et al. (2012) show that an

improvement in the relative bargaining power of firms weakens this direct tax incidence effect

(because workers capture a smaller share of the quasi-rent). Capital mobility plays no role in

their models because the bargaining power and position of firms and workers are exogenous

to the level of economic integration. However, as first shown by Mezzeti and Dinopoulos

(1991), a credible threat to shift production abroad improves the bargaining position of the

firm, and reduces the negotiated wage (see also Zhao, 1995; Eckel and Egger, 2009). As this

is particularly relevant for multinational firms that can easily shift production across borders

(Eckel and Egger, 2009),

1

we could expect direct tax incidence to increase with economic

integration (or, at least, corporate internationalisation). In the presence of competitive labour

markets, the incidence of the corporate tax on wages is indirect and results from variations in

the level of capital-to-labour invested in each country. As shown by Harberger (1995), an

increase in capital mobility in such a setting allows capital owners to partially escape taxation

via investments in low-tax countries. This capital outflow from a high tax country strengthens

indirect tax incidence by reducing the marginal productivity of labour in this country.

Overall, therefore, capital mobility and corporate internationalisation could strengthen the

inter-relations between wages and corporate taxes (either directly or through its influence on

the wage bargaining process). We test this intuition by analysing how economic openness as

well as the bargaining power of workers relative to firms influences both the tax incidence

and fiscal compensation effects.

In the next section, we briefly discuss the existing theoretical and empirical literature on

corporate tax incidence and fiscal compensation, and thereby highlight the potential role of

capital mobility on both effects. Then, Section 3 presents our methodological approach and

main empirical results. Section 4 concludes.

2. LITERATURE OVERVIEW AND HYPOTHESES

a. Corporate Tax Incidence on Wages

Corporate taxes can be passed on to workers by lowering wages. This can arise via various

mechanisms depending on the time horizon and the labour market structure. The overall inci-

dence of the corporate tax on wages can be decomposed into a direct effect in the short run

and an indirect effect in the long run (Arulampalam et al., 2012; Fuest et al., 2012). The

direct effect captures the incidence of the corporate tax on wages in the presence of a wage

bargaining process, for given capital stock and output prices. Specifically, a rise in corporate

taxation depresses wages by reducing the quasi-rent over which workers and firm can bargain.

In the long run, however, corporate taxes also influence wages through the adjustment of the

capital stock per worker or output prices (known as the indirect tax incidence effect). This

arises because the corporate tax first exerts a negative influence on capital investment, which

reduces the capital-to-labour ratio. This, in turn, reduces the marginal productivity of labour,

and the resulting wages, in the presence of competitive labour markets.

1

For example, Goodyear decided to fall back on imports from subsidiaries abroad after a major strike

of steelworkers in the United States and Canada in 2006 in order to limit the harmful impact of these

strikes on production.

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